OPPORTUNITY COST

Simply stated, an opportunity cost is the cost of a missed opportunity.
Applied to a business decision, opportunity cost might refer to the profit
a company could have earned from its capital, equipment, and real estate
if these assets had been used in a different way. The concept of
opportunity cost may be applied to many different situations. It should be
considered whenever circumstances are such that scarcity necessitates the
election of one option over another. Opportunity cost is usually defined
in terms of money, but it may also be considered in terms of time,
person-hours, mechanical output, or any other finite, limited resource.

Although opportunity costs are not generally considered by
accountants—financial statements only include explicit costs, or
actual outlays—they should be considered by managers. Small
business owners should factor in opportunity costs when computing their
operating expenses in order to provide a bid or estimate on the price of a
job. Opportunity costs increase the cost of doing business, and thus
should be recovered as a portion of the overhead expense charged to every
job. Ignoring opportunity costs may lead small business owners to
undercharge for their services and overestimate their profits.

EXAMPLES OF OPPORTUNITY COSTS

One way to demonstrate opportunity cost lies in the employment of
investment capital. For example, a private investor purchases $10, 000 in
a certain security, such as shares in a corporation, and after one year
the investment has appreciated in value to $10, 500. The investor's
return is 5percent. The investor considers other ways the $10, 000 could
have been invested, and discovers a bank certificate with an annual yield
of 6 percent and a government bond that carries an annual yield of
7.5percent. After a year, the bank certificate would have appreciated in
value to $10, 600, and the government bond would have appreciated to $10,
750. The opportunity cost of purchasing shares is $100 relative to the
bank certificate, and $250 relative to the government bond. The
investor's decision to purchase shares with a 5percent return comes
at the cost of a lost opportunity to earn 6 or 7.5 percent.

Expressed in terms of time, consider a commuter who chooses to drive to
work, rather than using public transportation. Because of heavy traffic
and a lack of parking, it takes the commuter 90 minutes to get to work. If
the same commute on public transportation would have taken only 40
minutes, the opportunity cost of driving would be 50 minutes. The commuter
might naturally have chosen driving over public transportation because he
could not have anticipated traffic delays in driving. Once the choice has
been made to drive, it is not possible to change one's mind, thus
the choice itself becomes irrelevant. Experience can create a basis for
future decisions, however: the commuter may be less inclined to drive next
time, knowing the consequences of traffic congestion.

In another example, a small business owns the building in which it
operates, and thus pays no rent for office space. But this does not mean
that the company's cost for office space is zero, even though an
accountant might treat it that way. Instead, the small business owner must
consider the opportunity cost associated with reserving the building for
its current use. Perhaps the building could have been rented out to
another company, with the business itself relocated to a location with a
higher level of customer traffic. The foregone money from these
alternative uses of the property is an opportunity cost of using the
office space, and thus should be considered in calculations of the small
business's expenses.